Buying Stocks at Record Highs: Will You Be Sorry?

Hedge-fund manager Carl Icahn says he is “very cautious” on U.S. stocks, which “could easily have a big drop” from their new record highs. Ben Inker, a director at asset manager GMO, forecasts that overall, U.S. stocks will suffer losses of 2% annually, counting dividends and inflation, through 2020. Yet billionaire investor extraordinaire Warren Buffettsays the U.S. stock market is valued “in a zone of reasonableness.”

So who is right?

In fact, whether stocks are overvalued or fairly priced isn’t the question that investors should be asking. Instead, what you need to answer is this: How much can I stand to lose before I will bail out?

Experts can’t tell you that, but history and what’s in your own head can.

David Salem, chief investment officer at Windhorse Capital Management in Boston, says figuring out how much financial misery you can stomach is “the only logical starting point for any comprehensive investment program.” Why? Because even if your assessment of market valuations is perfectly accurate, that won’t do you any good if you lack the financial or psychological fortitude to follow through.

Asking the right question is especially important right now. Like a cushy sofa, a bull market can lull even the most anxious people into a drowsy sense of comfort.

Both the Dow Jones Industrial Average and the S&P 500 set record highs this week. Counting dividends, U.S. stocks have returned 29% so far this year. If returns stay flat through year-end, 2013 would rank as the 19th-best annual return since reliable data began in 1926.

About $23 billion flowed into U.S. stock mutual funds in the four weeks ended Nov. 13, estimates the Investment Company Institute, after more than $37 billion flowed out over the previous 12 months.

The only significant asset that has lost value this year is anxiety: Gold and the CBOE Volatility Index, the so-called fear indicator, have both fallen more than 25% since Dec. 31.

Mr. Salem has an elegant solution for investors unsure what to do. Stop thinking about how much your stocks might return. Instead, think about risk first.

He suggests unwinding, perhaps over a glass of wine, as you ponder your investments. Size up how much money you have in stocks—not in percentages, but in dollars. “It’s dollars that drive the bailout impulse,” he says.

Let’s say you have $400,000 in stocks and stock funds. Between November 2007 and March 2009, U.S. stocks fell 51% and foreign stocks 57%, according to Morningstar. Another such “drawdown” would shrink your portfolio by more than $200,000.

Even if you don’t think stocks are as overvalued as they were in 2007, imagine a drop just half as severe. Can you withstand a short-term loss of $100,000 in pursuit of longer-term gains?

You can perform the same exercise on any of your assets. Real-estate investment trusts lost 68% between February 2007 and February 2009, according to Morningstar. Gold fell 62% between February 1980 and September 1999, while long-term government bonds lost 21% from July 1979 to September 1981. (Account for inflation, and all these numbers look worse.)

Financial history never repeats itself exactly, but it always rhymes. So while those losses aren’t predictions, they are guidelines.

You need to be “both willing and able to bear the loss,” says Mr. Salem. “Willingness is behavioral, ability is financial, and you can’t know for sure in advance which one is going to trump the other.”

So the best indication of whether you can take such a big hit is what you did the last time something similar happened.

If, in 2008 and 2009, you bought more of any asset that fell in price, you are the rare investor whose intentions and actions may match. If you did nothing, you at least didn’t turn temporary losses into permanent ones by selling out at the bottom. If, however, you did bail out, then don’t fool yourself into thinking you won’t do it again.

None of this means you shouldn’t own stocks—or any other asset. It just means you have to think more honestly about what you are getting yourself in for.

Mr. Salem believes many of the biggest investors in the world have made the same mistake of projecting return without first confronting risk. “Institutions are just groupings of individuals,” he says.

For 18 years, Mr. Salem was president of the Investment Fund for Foundations, a firm that by 2010 was managing $8 billion exclusively for charities and other nonprofit organizations. He left that year to work full-time at Windhorse, which manages more than $250 million for wealthy families.

“History is littered with people who chased return on the way up,” says Mr. Salem, “and then ended up converting what should have been temporary decrements to wealth into permanent ones by abandoning assets at the bottom.”